The buy-and-hold fallacy
You might opt for “stocks for the long run,” but the longer the run the bigger the mistake you are likely to make.
For years, the idea that stocks were less volatile over the longer term, as espoused by Jeremy Siegel in his 1994 bestseller “Stocks for the Long Run”, underpinned much portfolio construction. Investors reasoned that taking a long view allowed them to ride out periods of high volatility while still benefiting from stocks’ superior excess returns.
While there may be many reasons not to bail out in the midst of the kind of market volatility we’ve so recently experienced, the conviction that stocks will be less volatile over extended periods appears not to be the case.
That’s the upshot of research by Lobos Pastor of the University of Chicago and Robert Stambaugh of the University of Pennsylvania, whose paper on the subject recently won the Whitebox Advisors award for best financial research of the year.
“Buy and hold is riskier than the conventional wisdom would suggest. You are facing more volatility than maybe your financial adviser told you,” Pastor said in an interview.
Looking at 206 years of equity returns data, the authors find that annualised volatility rises with the time horizon, rather than diminishes. Although we know that historical stock market returns have been superior, this tells us nothing solid about what to expect in the future.
Investors then must make assumptions about what future returns will be, assumptions that almost invariably turn out to be wrong.
The farther away in time you get from an assumption, the greater the impact of any error and the greater the level of volatility we must assume in returns. This more than outweighs the tendency of returns to revert to the mean.
The research does not undermine equities’ claim to superior long-term returns but does do serious damage to the free lunch concept that we can enjoy high returns and, if only we are patient, be insulated from volatility.
This is a big concept and it’s worth considering in some detail what the implications might be.
First off, and perhaps least controversially, the authors believe this implies that many “target date” funds will be carrying too much in equities.
Target date funds, which held US$429 billion as of the first quarter, are designed to reset their asset allocation as a specific date, such as an investor’s retirement, approaches.
Because these funds may be making overly optimistic assumptions about long-term volatility, they likely will be holding too much in equities.
Dead hand of the past
Of course the research makes no claims about the volatility of other asset classes, and so we have no definitive reading on how best to construct a portfolio.
The big impact from this data, as it is absorbed, won’t be in how it affects people who were using Siegel’s data carefully, but the longer-term impact on the legions who got a vastly simplified and never true sales pitch that equities were both high-return and low-risk.
Equities, quite simply, were over-sold by the industry these past 20 years, in part because they were misunderstood and in part simply because they offered better opportunities for salespeople to profit.
While it is impossible to blame the buy-and-hold myth for the last two equity downturns, it is very likely that many investors suffered more than they ought to have due to it and, crucially, this idea fed into the formation of the successive equity over-valuations.
The upshot now is that many people are likely way overweight equities and will have suffered as a result. That is going to contribute to two trends:
First, the cult of equities will slowly decline, and with it structural allocation weights. This cult was a social phenomenon on the way up, and so it will be on the way down, meaning that the process will be long, slow and will overshoot. At some point this is going to make equities a screaming buy, but it may be a long, painful journey there.
Second, balance sheet repair by U.S. households will be another long-running trend. Many investors saved too little because they made optimistic assumptions about returns and volatility in their portfolios. They are now facing retirement with less than they hoped. The slow dawning of this will push savings rates higher, acting as a brake on economic growth. Savings rates, again, are a social phenomenon rather than a purely rational one, and this could be a big one.
It also will be interesting to see if institutional investors change their behaviour.
While charities and universities theoretically should have an infinite time horizon, many have been sorely hurt by poor returns in recent years. Many will react to this by increasing risk (and fees out the door) by plunging into private equity and hedge funds. Many too may well cut risk and equity allocations. A similar tension will be found in pension funds.
In the long run, none of this changes anything about equities’ superior long-term returns, but in the long run, as John Maynard Keynes said, we are all dead.
The journey between here and there is a bit riskier than perhaps we have assumed.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at firstname.lastname@example.org )